- Equity is a slice of company ownership that founders exchange for investor funding or offer as an employee benefit
- It is critical that founders share ownership equitably based on their role and commitment to the business
- Prospective employees should project the value of their founder equity split at exit to help determine total compensation
What is equity in a startup?
Essentially, startup equity describes ownership of a company, typically expressed as a percentage of shares of stock. On day one, founders own 100%. If you have more than one founder, you can choose how you want to share ownership: 50/50, 60/40, 40/40/20 etc. depending on how many founders you have and their contribution to the success of your company. However, to build your business, you will likely need to exchange equity for funding and to lure new employees.
Early on, founders need to give up a significant percentage of equity to match the risk investors are taking by funding your startup. But as you grow and demonstrate greater success, your startup equity increases in value and investors are typically willing to pay more — or inversely accept less equity in exchange for their funding.
When VCs invest capital in exchange for equity in your company, you are forming a business relationship. If your company turns a profit, investors make returns proportionate to the percentage of equity they have in your startup. On the other hand, if your startup fails, the investors lose their money. However, VCs are willing to take this risk because owning a percentage of a successful startup can be very profitable — and keeps the ecosystem moving when they use the proceeds to make investments in the next generation of startups.
Stock, shares and equity — what’s the difference?
“Stock” and “equity” are often used interchangeably. Stock is a general term — much like equity — that is used to describe an amount of ownership interest your company. Shares, on the other hand, are how your company’s stock is divided.
Your percentage of ownership is equal to the number of shares you own divided by the total number of shares:
Startup equity distribution among employees
Equity is the currency of the tech and startup worlds. After founders divide the initial ownership among themselves and investors, they also use it to attract talent. Like VCs, these early-stage employees are taking on risk and you need to compensate them for the salary cut they will likely take and long hours they will put in. Startup equity offers, however, also help to retain employees with the prospect of a big payday when the company exits through a buyout or Initial Public Offering (IPO).
Equity is the currency of the tech and startup worlds.
But how much equity should you offer? And what are the terms? There are general rules, but essentially the younger and smaller your company, the more startup equity you’ll need to offer.
How to share your startup’s equity wisely
There’s no correct answer for deciding the equity split among founders. More often than not, they default to a 50/50 split or another equal distribution to avoid an uncomfortable conversation. It’s an issue that can lead to big problems in a company’s future if not properly aired.
Sometimes a 50/50 split simply doesn’t make sense. Founders have different skills and commitment to the business. People can be in different stages in their personal lives, and founders play different roles.
“Generally, the CEO gets more,” says Peter Pham, a serial entrepreneur, angel investor, startup advisor and cofounder of Science, an incubator in Santa Monica, California. Pham cites a team that came into Science assuming they’d split their company 50/50. “We had to tell them, ‘Look, it can’t be 50-50. Because you’re the CEO and your partner is not, and the value of their role will diminish over time and yours will increase,’” Pham says. While the non-CEO founder deserved a large stake in the company, “the equity should be split based on value creation,” Pham adds.
The key is to have a serious conversation about ownership early on.
How to split your company safely
The key is to have a serious conversation about ownership early on. Figuring out what’s right for your team begins with a frank conversation. Discuss expectations, risk profile, commitment and personal circumstances. It is critical that founders “understanding deeply each other’s interests and intentions,” says Roy Bahat, head of Bloomberg Beta, an early-stage venture firm backed by Bloomberg L.P.
Contributions to evaluate should go well beyond skills, experience and contributions solely at the time of founding. For example, the initial idea on which the company was founded has value, and whomever dreamed up the initial concept should be fairly compensated. But the concept is only part of the evaluation, as it may be worth little unless realized through execution.
Peer into the future and anticipate how things might evolve. Bahat advises founders to think broadly. “I think it’s one of the most important decisions that founders make,” he says. Equity calculators can also help guide your discussions.
Build an equity distribution program
It will be necessary to offer startup equity to recruit board members, advisors and key employees, but sharing out equity is a challenge for first-time founders. And the stake an employee receives depends on a range of factors, from skills to seniority and their original contribution when they’re hired.
Serial entrepreneur Joe Beninato asks, “What’s the experience of the person coming over? You have to look at each situation individually.”
Position and seniority play a big role in deciding whether to offer 1% or .05%. There are guides online that provide compensation benchmarks like Index Ventures and Holloway Guide to Equity Compensation to help founders decide the size of each slice of the company they give away when signing talent.
At a company’s earliest stages however, you can expect to give a senior engineer as much as 1% of a company. But an experienced business development employee would typically receive only a .35% cut. An engineer coming in at the mid-level can expect .45% versus .15% for a junior engineer, and so on. But Beninato says, “The percentages really vary dramatically. I don’t want to say it’s like a decaying exponential, but it’s something like that. The first people get more, and it goes down over time.”
… equity compensation is always subject to vesting schedules.
Regardless of its form, equity compensation is always subject to vesting schedules. You need to reward your team for staying with your company, and startups have typically used a four-year benchmark with a one-year cliff — this means, no ownership percentage is granted until an employee has worked at least twelve months. However, longer vesting schedules are becoming more commonplace as startups take longer and longer to exit.
But keep in mind that equity is finite, so spend it carefully.
Crafting your startup’s exit strategy
Having a successful exit begins at the inception of your company and leadership team. Having the hard conversations early and fairly assessing everyone’s value to the enterprise is critical.
Having a successful exit begins at the inception of your company and leadership team.
Noam Wasserman, a professor of clinical entrepreneurship at the University of Southern California and founding director of USC’s Founder Central Initiative, studied more than 6,000 startups over 15 years and reported that startups that chose an even-split by default, bypassing difficult but important discussions, were three times more likely to have unhappy founding team members.
Unhappiness can even ruin success. “I’ve been at big liquidity events where everyone should be celebrating,” Scott Dettmer, a Silicon Valley-based lawyer who has been advising startups since the mid-1990s says. “But two of the three founders say, ‘The third is getting more than he deserves’.” Avoid that situation, or worse, by discussing equity splits early, fully and openly.
How to understand equity as an employee
If you’re thinking of accepting a job with a startup, you will likely be offered equity in addition to your salary and benefits. Because cash is usually tight at a startup, founders use equity to help offset below-market salaries.
Having equity means you own a portion of the business you’re helping to build. It is basically deferred compensation based on the hope that you will someday own a piece of a valuable startup. But equity packages vary tremendously. You need to know what you’re getting before you take equity as part of your compensation.
Before you consider or accept an equity offer, understand how equity works in a startup and be familiar with these eleven terms:
1. Four-year monthly vest
You’ll receive a fraction of your equity every month, but you need to remain with the company for four years before you receive the full amount.
2. One-year cliff
You need to stay with the company for at least one year to receive any equity benefit.
This is the “option” to buy shares of equity at a later date at a set price.
4. Strike price
This is the price you agree to pay for your options — the lower the better. If the strike price is higher than the value at liquidation time, the options are said to be “underwater”.
5. Nonqualified stock options
When you exercise your Nonqualified Stock Options (NSO), the difference between your strike price and the current market value will be taxed as ordinary income.
6. Incentive stock options
When you exercise your Incentive Stock Option (ISO), you don’t pay income tax. Instead, you pay capital gains tax when you sell shares. However, you may encounter an alternative minimum tax, so it’s best to consult with your tax advisor to understand your liability.
7. Liquidity event
This is when your company is acquired or goes through an Initial Public Offering (IPO). It is the moment when your company converts shares of ownership into cash and your equity has value.
8. Accelerated vesting
If your company is acquired before you finish your four-year vesting period, the rest of your equity is allowed to vest in the shorter time period.
9. 83b election
You can choose to pay taxes on the total fair market value of restricted stock when it’s granted instead of waiting until the stock is vested. Consult your tax advisor to see if this is a good option in your situation.
10. Preference stock
This is the amount of money guaranteed to investors and preferred shareholders — you, as an equity holder without preferred shares, will only receive a percentage of what is left.
11. Founder preferred stock
This class of stock is becoming more popular, and it enables founders to convert into any series of preferred stock sold by the company to VC's in a future round of financing. You would only choose to do this if you intend to sell those shares to investors.
How to evaluate your equity offer
Your equity is a nice-to-have, but it’s not something you can rely on like salary. It’s possible that you are joining a company that will have a sizeable exit and you’ll realize a significant bonus in years to come. But that may not happen. So first, it’s important to make sure you have a salary you can live with, and second you need a complete understanding of your equity offer.
To assess the potential value of your equity offer, you’ll need from your prospective employer:
Last preferred price
Hypothetical exit value
Number of options in your grant
All this information should be in your offer letter. However, if anything is missing, be certain to ask. You can then use an equity calculator to help you understand the potential value of your offer.
How taxes are affected by equity offers
Nonqualified Stock Options (NSO) and Incentive Stock Options (ISO) are taxed differently, and the difference could have serious tax implications. When you exercise NSOs, the spread between the strike price and your shares’ current market value is treated as ordinary income and you pay income tax. In other words, you’re paying taxes on money that you may only theoretically have.
Whereas with ISOs, they’re taxed at the typically lower capital gains tax rate, and only when you sell the shares. In this case, you’re paying taxes on money you actually have.
How vesting works
Your equity grant will usually be paid out according to a four-year vesting schedule. You’ll receive a fraction of your equity package each month, and four years later you’ll have your entire package.
With your vesting schedule typically comes with a one-year “cliff”. This means if you leave the company for any reason within the first year — even if you’re terminated — you’re not entitled to any equity benefits.
How a liquidity event impacts your startup equity offer
If your company is acquired or goes public before your vesting period is complete, one of three things can happen:
- You immediately receive the remainder of your startup equity grant — this is called accelerated vesting.
- You work for the purchaser or new public company and continue on your vesting schedule.
- You lose your equity startup grant and receive nothing.
Your employment contract should detail what happens after a liquidity event but accelerated vesting is clearly the best for turning your options into money.
It is important to understand your prospective employer’s plans — and timetable — before you can value your equity stake.
How to evaluate your company’s exit strategy
It is important to understand your prospective employer’s plans — and timetable — before you accept your position. Whether the founders keep the company private, choose to be acquired or go public through an IPO, it may impact your future with the company and the value of your equity options.
At a liquidity event — or exit — investors and other preferred stockholders are the first to be paid. This is called the “preference stock” and it can impact employees’ startup equity grants. To understand the impact the preference stock may have on your offer, there are three questions to ask:
What is company’s most recent valuation?
What is the rate of annual growth?
How much will the company need to sell for before my equity has value?
If the most recent valuation is close to or exceeds the needed sale price, your equity offer has value. However, if the needed sale price is much higher than the company's most recent valuation, you need to make a decision. Based on its current growth rate, how many years will it take for the company to reach the needed sale price? Are you comfortable investing that much time — or are you okay having equity options with little or no value?
The job may be a good opportunity for other reasons, but a clear understanding of your equity opportunity can help you make a more informed decision. To help evaluate the value of your offer, use this calculator.
When to sell your equity
If you’ve enjoyed a great experience and you now own equity that has significant value, when to sell is a personal decision. First, talk with your tax advisor to determine your tax liability, then assess your personal situation. If you don’t have any immediate need for the money and you’re confident that your equity will continue to grow, there’s no reason to sell. However, it may be wise to speak with a financial advisor to see if diversification is appropriate.
On the other hand, you’ve worked hard to make your company a success. Perhaps it’s time to use some of the money to treat yourself and your family.
Equity can be a terrific employee benefit, but do your research, ask the questions, project the value to create a complete picture of your offer, and enjoy your new job knowing you have a fair deal.
Running a startup is hard. Visit our Startup Insights for more on what you need to know at different stages of your startup’s early life.